There are several evolving environment, social, and governance (ESG) credit risks that we believe have the ability to materially impact an obligor’s credit profile, including: climate change, the rise of renewable energy, population loss, public pensions and retiree health benefits, and acrimonious budget negotiations and impasses. While ESG investing pertains specifically to a subset of factors that represent both risks and opportunities in a credit profile, this blog post focuses on ESG risks as they pertain to municipal bond investments. An article by Gurtin Municipal Bond Management.
ESG Risks Related to Municipal Bonds
For municipal investments, ESG risks describe credit risks that pertain specifically to environmental, social, and governance factors that could impact an obligor’s willingness or ability to repay debt. They encompass many of the credit factors with the potential to drive the most economic and financial disruption for municipal issuers, and represent some of the most rapidly evolving credit issues. As a result, ESG factors can be significant risk drivers for municipal bond investments, at times becoming the difference between gilt-edged investments and distressed credits.
ESG Factors Impacting Obligor’s Long-Term Creditworthiness
ESG credit risks typically involve factors affecting a community’s long-term sustainability. The following highlights several evolving ESG credit risks that we believe will receive higher levels of scrutiny over the medium term and are capable of materially impacting an obligor’s credit profile.
Environmental risks pertain to risks that negatively impact an obligor’s natural and built environment, including land, property, and natural resources such as water. ESG credit analysis also considers the potential impact of environmentally driven regulations and the fossil fuel transition on an obligor’s credit quality. Emerging environmental risks include climate change and the rise of renewable energy, which brings challenges that we believe could pose risks to public power utilities as well as local government obligors.
The growing climate crisis represents a significant emerging risk to municipal bond credit quality. Significant impacts, such as sea level rise, increased wildfires, and water stress, are expected as a result of climate change, and municipal issuers could face increased physical impacts of climate change sooner than many places are currently expecting. This is due to acceleration in global warming from rising greenhouse gas emissions in 2017 and 2018, declining air pollution, and natural climate cycles, which have led projections to show the Earth could warm at a faster rate than previously reported.1
Exposed obligors could see a significant negative impact on their communities from the physical impacts of climate change, as well as negative secondary effects including potential tax base or employment loss, population declines, and increased debt issuance, depending how a community and its population respond to the risk.
The Rise of Renewable Energy
Due to market forces and an increased sense of urgency around climate change, renewable energy grew from 9% of U.S. electricity generation in 2008 to 17% in 2017, with growth mainly in wind and solar.2 Across the country, U.S. states, cities, and counties are increasingly committing to power their communities with 100% renewable or carbon neutral energy, which could lead to an even faster rate of renewable adoption.3
Depending on how the transition is handled and how reliant a utility is on generators that run on fossil fuels like coal or natural gas, renewable energy transition could represent an environmental risk for electric utilities, as well as any local government obligors that may back utility debt or rely on the fossil fuel industry as a major employer or taxpayer. This is due to the potential fall-out of the rapidly changing energy market on electric utilities’ fossil fuel-burning assets or on communities reliant on the fossil fuel industry.
Social risks reflect characteristics of the people who will ultimately repay the debt, including taxpayers, ratepayers, customers, or students. Additionally, social risk can speak directly to the long-term sustainability and vitality of a community. Population loss is one such social risk and evolving ESG factor that we view to have a potentially negative impact on a community’s longevity.
An overall trend of population loss in parts of the United States, in particular in rural counties, has been well documented4 and is a difficult problem to resolve.5 In addition to rural areas, approximately 80 U.S. metropolitan statistical areas lost population between 2010 and 2017, which is nearly double the number that lost population between 2000 and 2010.6
Population loss can have a negative impact on a community’s longevity, as well as affect other municipal obligors in the area, such as regional colleges and universities or small community hospitals. This is because declining population can result in contraction in the tax base or revenue base. It also can leave an obligor with legacy assets that a smaller population will need to service, such as extensive, built-out infrastructure or unfunded pension liabilities.
Governance risks describe concerns regarding an obligor’s ability to effectively manage its financial operations. In assessing governance risks, we also consider potential political risks that could impact an obligor’s willingness to pay or that could trickle down to lower levels of government, such as state-imposed tax caps that affect local governments’ revenue-raising abilities. We note public pensions and retiree health benefits, as well as acrimonious budget negotiations and impasses, as increasingly significant governance risks that can impact obligors’ long-term creditworthiness include.
Public Pensions and Retiree Health Benefits
Many obligors continue to see pension and retiree health care contributions increase at a faster rate than revenue growth, which has raised concern that these costs could crowd out other expenditures. Management can play a significant role in deciding what level of contribution to make each year and which actuarial assumptions to use, which can have a sizeable impact on a pension plan’s funding status and prevent larger costs over the long term.
Acrimonious Budget Negotiations and Impasses
In recent years, political parties have become more partisan, making negotiations on budget, tax or revenue increases, and other legislative issues much more difficult. As an example, the increasingly hostile relationship between political parties escalated in 2015 when both Pennsylvania and Illinois ended up in protracted budget impasses. Pennsylvania finally ended its stalemate within about seven months; however, it took Illinois more than two years before its impasse ended, causing significant havoc and negative financial repercussions for the state in the meantime, including public rating downgrades.7
Closely Monitoring ESG Areas of Disruption and Change
In recognition of the potentially fluid nature of credit risks and opportunities, we have always viewed municipal credit analysis as an evolving discipline. Our approach to ESG analysis and incorporation of ESG factors across all our municipal bond strategies reflects our conservative philosophy to seek to purchase only bonds that we have identified as high quality with sustainable characteristics and to anticipate credit distress before major credit ratings agency downgrades can negatively impact the pricing of clients’ holdings.
To learn more about the potential ESG risks in your existing portfolio, request a complimentary portfolio review to receive a detailed assessment of the credit quality of your municipal bond holdings: Request Portfolio Review.
To learn more about Gurtin's approach to ESG analysis and how we incorporate ESG factors into the credit assessment of all our municipal bond strategies, request a complimentary ESG overview: Gurtin’s ESG Analysis Approach.
If you enjoyed this blog post and would like to read more, please visit:
• Fact vs. Fiction: Providing Clarity in Municipal Social Impact Investing
• SRI Report: Community
• SRI Glossary
See related Gurtin disclosures.
1 Note: The authors project that the Earth could pass 2.7 degrees Fahrenheit (1.5 degrees Celsius) of warming by 2030. Source: Xu, Yangyang, Veerabhadran Ramanthan, and David Victor. Global warming will happen faster than we think. December 5, 2018. Nature. https://www.nature.com/articles/d41586-018-07586-5.
2 What is U.S. electricity generation by energy source? U.S. Energy Information Administration. https://www.eia.gov/tools/faqs/faq.php?id=427&t=3
3 See our report, Spotlight on ESG Opportunities: This City Is Powered by 100% Renewable Energy for additional information on the expected risks and opportunities from communities committing to 100% renewable energy.
4 Cromartie, John. Rural Areas Show Overall Population Decline and Shifting Regional Patterns of Population Change. United States Department of Agriculture. Economic Research Service. September 2, 2017. https://www.ers.usda.gov/amber-waves/2017/september/rural-areas-show-overall-population-decline-and-shifting-regional-patterns-of-population-change/ .
5 Henderson, Tom. States Try to Counter Rural Flight. Pew Trust. August 20, 2015. https://www.pewtrusts.org/en/research-and-analysis/blogs/stateline/2015/08/20/states-try-to-counter-rural-flight.
6 U.S. Census Bureau 2017 and 2010 population change data for all U.S. metropolitan and micropolitan statistical areas. 8 of the top 10 population losses for metro areas in 2017 lost population on both lists.
7 Office of the Illinois Comptroller, Susana A. Mendoza. Consequences of Illinois’ 2015-2017 Budget Impasse and Fiscal Outlook. https://illinoiscomptroller.gov/financial-data/find-a-report/special-fiscal/consequences-of-illinois-2015-2017-budget-impasse-and-fiscal-outlook/.